The Fed’s Deal with the Devil

Today’s AFR runs an article by (London) Telegraph’s Ambrose Evans-Pritchard (“Fed makes a Faustian pact with inflation” p21).  Colloquially you may know a ‘Faustian Pact’ as a ‘Deal with the Devil’.  From the article:

“Interest rates in the United States have fallen to minus 2pc in real terms and are dropping into deeper negative territory with each passing month. This is a remarkable state of affairs.

It is clear that the US Federal Reserve is now trapped. The FOMC [Fed committee] dares not tighten despite core inflation reaching 2.3pc because it is so worried about tantrums in financial markets and about that other Sword of Damocles - some $11 trillion of offshore debt denominated in dollars, up from $2 trillion in 2000.

The Fed has been forced by circumstances to act as the world's central bank, nursing a fragile and treacherous financial system struggling with unprecedented leverage.

Average debt ratios are 36 percentage points of GDP higher than they were at the top of the pre-Lehman bubble in 2008, and this time emerging markets have been drawn into the quagmire as well by the spill-over effects of quantitative easing. Like it or not, the Fed is stuck with the task of cleaning up a global mess that is arguably of its own making.”

The problem with this procrastination/meddling is that it exacerbates the problem when finally addressed (too late).  The last example we saw of this before the GFC was when the Fed’s Greenspan slashed rates after the Asian Crisis but held them low too long… enter the dotcom bubble.

There is a double benefit for gold in these circumstances.  Gold historically loves negative real interest rates (interest rates less inflation).  The US is there as mentioned above and some countries (Eurozone, Japan, Switzerland etc) actually have negative interest rates - NIRP (even before inflation adjustment).  Australia is about nil.  Since introducing that policy Japan has sold out of safes as people are hoarding cash.  Inflation still erodes cash value whereas gold usually protects against inflation. All that printed money since the GFC could well see a sudden surge in inflation if we actually see the velocity of money respond at last.  

The second benefit is that history is littered with examples of the Fed tightening too late.  When it finally acts, it causes a market crash.  We’ll leave you with the final paragraph of the article accordingly:

“The world’s financial markets chose to celebrate Janet Yellen's reprieve on Wednesday. But there is another side of this Faustian pact. The tightening shock will be even more painful when it finally comes.”